See
also:General Index of all guest columns written by Dennis C. Butler,
CFA

JANUARY
2016

O

n December
14, 2015, a curious thing happened in the U.S. stock market. Looking at the
popular barometers one
would
think that prices were up nicely: the Dow Jones
Industrial Average added 0.6%; the S&P 500 index gained 0.5%; and the Nasdaq
Composite rose 0.4%. But on the NYSE, so-called “market internals¯” painted a
very different picture: 2300 issues (or 72% of the total) saw price
declines; 572 stocks recorded new low prices for the trailing twelve-month
period (versus 7 new highs); and trading volume in decliners exceeded that
of gainers, 2.8 to 1.6 billion shares. Far from being an isolated
occurrence, this pattern had been repeated on numerous occasions during 2015
as the market's advance, meager as it was, became increasingly “narrow.” By
late November a small group of five
issues accounted for the entire rise in the S&P of about 1% at that time;
most stocks in the U.S. had declined in price.

This
phenomenon (an odd effect of the way in which the indexes are constructed)
happens occasionally and has been far more pronounced at times in the past.
In 1929 and 1999, for example, just before markets suffered sharp plunges,
small numbers of stocks lifted the averages to extraordinary heights. We
don't mean to imply that such statistics will consistently foreshadow bear
markets; rather, their usefulness lies in clarifying investment results that
appear to be out of kilter with market averages. During a period of
generally declining stock prices — ¯whether reflected in the indexes or
not — investors will find it difficult to make much headway. When the market
gauges act in the peculiar fashion noted above, weak relative returns often
cause dismay among the less sophisticated and lead to bad decision-making
(such as chasing high-flying stocks). This is one reason why it is wise to
largely ignore short-term results and to always view them in the context of
general market conditions.

Among the
S&P 500 stocks, 284 finished lower for the year, continuing the “bad
breadth

” pattern noted above, and in keeping with the stock market's
listlessness during the past two years. Trading finished 2015 on a low note,
a sign of nervousness about the usual suspects — economic conditions,
corporate earnings, and falling oil prices. The averages were slightly
positive for the year, with gains in the Dow Jones and S&P 500 indexes
limited to 0.2% and 1.4% respectively (including dividends). The NASDAQ
Composite reflected enthusiasm for the popular technology issues of the day
and rose 5.7%.

Potential
U.S. Federal Reserve actions and havoc in the oil markets dominated
financial news during 2015. After nearly a decade of extraordinarily easy
monetary policy, market participants expected the Fed to begin reigning in
the largesse in the face of improved economic conditions. Waiting too long,
it was feared, could risk inflation. Many Fed officials, on the other hand,
were wary of squelching a recovery that was not very robust. Despite the Fed
claiming that its decision-making process was “data dependent,

” observers
obsessed over every monetary policy committee meeting, and were upset when
decisions did not match their expectations.

We believe
that far too much attention is paid to the Fed's periodic deliberations.
Like the “Kremlin Watchers

” of the Cold War era, observers attempt to divine
meaning and intention from every change of personnel and every nuance of the
central bank's communications. Indeed, we would prefer that the bank return
to its past secretive ways for this very reason. In the greater scheme of
things, these minor moves make very little difference, and from our
perspective they have almost no impact on investment policy. The Fed acted
vigorously to prevent a financial crisis from turning into a catastrophic
depression. This was an important
event, particularly as it gave the public and investors confidence that the
Fed would act aggressively to prevent broad swaths of business earning power
from being wiped out in a prolonged, severe downturn such as occurred in the
1930s. That the Fed no longer acts as if it believes corporatized,
limited-liability capitalism to be, in any important sense, self-regulating
is also significant in that it instills hope that the probability of a
future crisis has been at least somewhat reduced.

R

egarding
the oil markets, the fall in prices to eleven-year lows was a source of both
wonder and worry. While a boon for consumers, low prices caused pain in
exporting regions from Texas to Russia. Petroleum-based economies will
likely slow further, meaning fewer imports and less business for trading
partners, and there will be fewer petrodollars circulating for investment.
Indeed, sovereign wealth funds have already begun liquidating securities
portfolios to cover budget deficits. Given the fact that some petroleum
exporters have oil-financed social welfare schemes as well, the potential
for social tension is also greater, an unwelcome development in areas such
as the Middle East.

While we
would not dream of attempting to forecast the market for a commodity such as
oil, we believe there is a growing probability of significantly higher
prices over the next several years. Trends contain the seeds of their own
destruction, a process that is already evident in the oil markets. As the
price slide lengthened to 18 months (crude prices fell over 30% in 2015
alone), major oil companies cut their exploration and development budgets by
over $250 billion due to poor project economics at current prices. This
means that less energy will be available to tap in the future. Meanwhile,
spurred by lower prices, demand continues to rise (SUVs are back in vogue in
the U.S., for example). It has been estimated that over the next several
years the draw on the world's oil resources due to growing use and,
importantly, reservoir depletion, will more than offset potential new supply from
producers such as Iran (the country plans to resume exporting immediately
upon the ending of sanctions), Libya or Venezuela. If this comes to pass,
along with insufficient investment, there will be interesting times in the
energy sector going forward. Meanwhile, hedge funds have increased their
short positions (selling a borrowed asset in the expectation of buying it
back later at a lower price) in the oil markets to the highest level on
record — ¯a contrary indicator if ever there was.

“Financial
markets are always on an earthquake fault and that fault can move at any
time,

” opined a Georgetown University professor using an analogy that, if
not entirely accurate, is descriptive of markets during speculative
frenzies. At such times, the slightest slippage in what was thought to be
solid bedrock can cause extreme ructions, and it is precisely at those times
when it is critical to remember that the primary goal (and responsibility)
of the investor is not to aim for the highest return possible, but rather,
to preserve capital. To be sure, an
adequate return is important, but always secondary to the goal of
capital conservation. This is why the investor must be able to identify the
fault lines of risk before pressures rise to the breaking point. Risk
aversion is, therefore, a key part of the investor's toolkit.

Recently
Gillian Tett of the Financial Times
penned an insightful piece on the risks that have developed as a result of
the prolonged easy monetary policies in place since the financial crisis.
While all eyes focused on the Fed last month, an obscure government office
issued its inaugural Financial Stability Report. The Office of Financial
Research (OFR), set up after the crisis, studies risks in the U.S. financial
system, of which Tett discussed three, all of which are basically related to
the investment world's desperate “reaching for yield¯

”
in an environment of
ultra-low rates.

First
discussed was credit risk, the possibility a debt issuer will have trouble
meeting its obligations. Credit risk has risen as corporations have taken
advantage of low rates and tremendous demand for income-producing assets to
increase their debt loads. More debt in itself might not be a big problem
were it not for the fact that the funds so raised have generally not gone to
business investment or R&D, but instead to things like financial engineering
and “balance sheet efficiency.

” In other words, corporations have been busy
buying back their shares (useful if you want to cash in stock options),
paying out dividends, and pursuing merger deals. Such practices are not
necessarily pernicious, but buying back shares at high prices (almost always
the case) or paying out more in dividends than you earn (making up the
difference with debt) is not sustainable. Mergers motivated by low capital
costs are also suspect as cheap capital encourages higher bid prices for
targets and transfers value to sellers.

Much of
that demand for debt issuance came from managers of fixed-income funds
engorged with cash from investors seeking the safety of fixed-income
investments. These managers, to satisfy their craving for yield, have
purchased everything from investment grade paper to junk debt issues
structured to provide few protections for buyers. As a result, “portfolio
risk

”
has increased, leaving fund investors vulnerable to potentially steep
declines in value in the event of rate increases or economic difficulties.
The OFR estimated that fund losses of over $200 billion could occur with a
one-percentage point rise in long-term U.S. interest rates. Holders of
supposedly “safe” bond funds could be in for a surprise. Many are not
waiting; since the beginning of June 2015 U.S. fund investors have pulled
roughly $36 billion out of both investment-grade and junk bond funds,
leading the market for junk to post its first annual loss in several years.

The third
risk results from a shift of cash equivalent investments that has resulted
in hundreds of billions of dollars moving out of money market funds and into
banks and the Federal Reserve. This massive transferral of funds may
eventually disrupt the functioning of normal Fed monetary policy, which
involves the buying and selling of money market instruments such as treasury
bills. There is also the possibility that any return of this cash to money
funds as conditions normalize could impact the financial system in ways that
no one yet understands or can predict.

As
investors, we do not need to know what will happen in the future — an
unattainable goal in any case. We do need to be aware of underlying risks,
especially when they are not generally acknowledged or understood. Today's
risks from monetary largesse may have an analogue in the overheated property
markets of the last decade; now, we must prepare for the aftermath of an
overheated bond market. Ten years ago, we were very wary of the real estate
bubble, and advised staying away from property. The OFR's assessment may
describe risks that have a less direct bearing on individuals' lives and
choices, but anticipating their potential aftermath and protecting against
it is critical in meeting the investor's primary goal of capital
preservation.

______________

Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over
33 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at
www.businessforum.com/cscc.html

.

"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the
Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of
NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of
Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or
"What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at